Indicators That Help in Predicting Stock Market Crashes

The stock market tends to run in cycles. For a couple of years, the market maintains a bullish stance. Then some catalyst incident happens, and it seems like the market has suddenly taken a plunge. However, this is usually not the case in reality.

Markets neither rise nor fall overnight. The catalyst incident merely sparks the downfall which is then continued by momentum. This momentum is sustained by how far, the market had deviated from the equilibrium level.

In simple words, if the market went way too high, then the crash will also be rapid and steep.

For instance, the 2008 crisis was not sparked by the fall of Lehman Brothers. Instead, the downfall was already brewing for quite some time the Lehman brothers fall only catalyzed the incident. The same is the case with the dot come bubble or any other crash that has happened in the history of stock markets.

The catalyst incident is not the actual cause of the downfall. Many experts believe that the downfall or the crash can be easily predicted if one pays attention to certain indicators. Savvy investors can pay attention to these indicators and look for the exit point. This is why they tend to generate wealth both in a rising as well as a falling market.

In this article, we will have a look at some of these indicators and how they combine to create a stock market crash.

  • Rampant Speculation: The first step towards the downfall is when speculation becomes rampant. This rampant speculation ensures that a positive feedback loop is prevalent in the market. Hence, the stocks are driven higher than their true value. As a result, a bubble is created. Current high prices become the reason for expecting future hikes in prices.

    To most savvy investors, the creation of this bubble is the first step that predicts a market downfall. Minor market corrections often deflate smaller bubbles. However, when the bubble continues for an extended period, the result is a market crash. The fall in prices is often steep giving the investors almost no chance to recover. The safe thing to do is to err on the side of caution. This may mean that the investor might make less money. However, the risk of losing money is also reduced considerably. Hence, speculative bubbles must not be ridden till the peak.

  • Low Growth Rates: A slowdown in the overall economic growth is a significant indicator that the stock market is going to crash. A slowdown, by itself, does not mean that the market will collapse. However, rampant speculation and slowdown in the growth rate are a potent combination.

    They have sent stock markets crashing down several times in the past. Economists have several indicators which they use as a barometer for economic growth. The gross domestic product (GDP) is amongst the most common of these indicators. Other factors such as unemployment, inflation, etc. are also taken into account. If these indicators are in the negative over a specified period of time and the market is still booming, then there is a disconnect between stock markets and economic reality. This irrational exuberance usually does not end well. Hence, the co-existence of the above mentioned two conditions is an indicator that the holdings must be liquidated.

  • Peak Valuations: The valuation of stocks is often at its peak just before a market slowdown. For instance, if historical records show that the average stock has traded at 15 times EBIT and at the present moment the same stock is trading at 27 times EBIT, then the valuations are stretched. The stocks of even good companies fall when valuations are fairly stretched. The historic record should not consider very long periods of time. Recent price movements are more accurate indicators of the valuation of the stock. The ideal range would be around 3 to 5 years.

  • Low-Interest Rates: The root cause of any kind of bubble is the presence of too much money in the market. When central banks lower interest rates, they incentivize banks to create more money by the fractional reserve lending process. This process has almost always led to a bubble and crash in the long term.

    The reason is that once the interest rates are lowered, more money floods the markets. This leads to mal-investment and crowding out. The end-result of the process is that one asset class like real estate or stocks ends up getting extremely heated. Now, the bubble is built on artificially created fiat money. Hence, it cannot continue forever. Sooner or later, the central bank has to raise interest rates to control rising inflation. This interest rate rise leads to a fall in the asset prices because it sucks out all the additional money from the market.

The history of market bubbles is pretty clear. All bubbles right from the housing boom to the subprime mortgage lending were all created in the presence of rock-bottom interest rates. Hence, when investors see the interest rates being kept low for an extended period, they should be wary that a bubble may be underway.

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